TERM CURRENCY CONTRACTS (FORWARDS)
A manufacturer has to make a $500,000 payment on November 1st. To do this he must have the funds in his account and wire it to his supplier.
He decides to enter into a term contract (forward) with the bank in order to fix the rate at which he would buy the dollars in six months' time with BGN.
When the exchange rate of the forward contract is determined, it should be beyond the current market rate. The difference reflects the expected change in the value of the currencies on the future value date i.e. it reflects the interest rate differential of the two currencies. If the current market rate of USD/BGN is 1.5000, the market interest rate for the period for dollar deposits is 6% and the market interest rate for BGN (for the same period of 6 months or 180 days) is 4%, then the forward exchange rate will be:
Forward Rate = 1.5000 x [1 + (0.04 x 180/360)] / [1 + (0.06 x 180/360)] = 1.4854
Thus the dollars will be bought on a future value date at a rate of 1.4854, provided that the spot rate is 1.5000 and the interest rates are the same as in the example.
Why is this rate lower than the market rate? Because whenever the interest rate on the first currency in a pair (in our case USD/BGN) is higher than that on the second one, then the rate on the future value date is quoted at discount. This is the compensation for the lower interest rate of the second currency.
Why is it the case? Because while the manufacturer has two alternatives, both result in the same outcome:
- He can buy the dollars with a forward contract.
- He can purchase the dollars at the current market rate; he can deposit them for 6 months and collect the accrued interest.
With similar calculations, we arrive at the conclusion that if the manufacturer wanted to sell dollars for BGN he would make it at a higher forward rate than the current one. This is because the discount at which USD/BGN is quoted is for a future value date (more than two business days away).
As for the collateral, the manufacturer who has just negotiated the rate of the forward contract with the dealers must freeze 10% of the value of the contract. In our example, the value of the contract is $500,000. Therefore the collateral that should be frozen until the value date (November 1st) is $50,000 (10% of $500,000).
On November 1st the manufacturer must have 742 700 BGN (500,000 x 1.4854) available in his BGN account in exchange for the $500,000.
To summarize: The manufacturer will profit, if on November 1st the USD/BGN market rate is higher than the forward rate he contracted for on the 1st of May.
If the manufacturer wishes, he may use another method to hedge (safeguard against unfavorable exchange rates). This instrument is called an option.
Unlike the forward, it gives the manufacturer the right (but not the obligation) to buy the dollars on a future date at a fixed rate set by him today. This is unlike a forward contract where he doesn't have a choice - he must conclude the transaction at a rate fixed in advance.
A further difference from the forward is that the option gives the manufacturer the right to choose the level at which the transaction will or will not be executed (the manufacturer has the right to choose between the rate set by the option and the market rate).
With regard to the rate at which the transaction will be executed (the fixed rate set in advance is called strike), there are three types of options:
- In the money option - the manufacturer chooses to purchase the dollars at a strike price lower than the current market rate.
- At the money option - The manufacturer chooses a strike price equal to the current market rate.
- Out of the money option - The manufacturer chooses a strike price which is higher than the market rate.
Logically, in the first case the option premium (price) should be the highest. Similarly, the premium for the third type of option should be the lowest.
Let's assume that the manufacturer wants to buy the dollars at the current market rate in six months time i.e. the strike price = current market rate which is supposedly 1.5500.
In this case, let's say the price the manufacturer has to pay for the right to buy 100,000 dollars at this rate in six months time is 4,000 BGN. What does this mean? It means that on May 1st, if the manufacturer decides to buy the option he has to pay on the same day 4,000 BGN. This is the price for the right to choose between the fixed rate and the market rate (November 1st) for the purchase of his dollars.
When does the manufacturer make a profit? He does so if on the delivery date (November 1st) the exchange rate of USD/BGN is higher than the fixed rate i.e. if the dollar has increased its value to let's say 1.6000. In this case he makes a profit of 5,000 BGN due to the fact that he can exercise his option and buy the dollars at 1.5500 ($100,000 X 0.05 BGN difference).
Are these 5,000 BGN his net profit? Not really. We need to subtract the price of the option, which is 4,000 BGN. Therefore, if on November 1st the market rate is 1.6000, his net profit will be 1,000 BGN. The breakeven rate (the rate at which the manufacturer is fully compensated for the purchase of the option) is: 1.5500 + 4,000/100,000 = 1.5500 + 0.04 = 1.5900.
In other words, only when the USD reaches a rate of 1.5900 or higher does the manufacturer break even or make a profit.
Note: The maximum loss the manufacturer can suffer is the price paid for the premium - 4,000 BGN because:
- If on November 1st the market rate of USD/BGN is lower than that fixed by the option (1.5500), the manufacturer chooses not to honour his right to exercise his option, but rather lose the premium and buy the dollars at the market rate.
- If on November 1st the market rate of USD/BGN is higher, he may choose to exercise his option and buy the dollars at the lower fixed rate (1.5500). Even if the market rate is not at a breakeven level, the manufacturer would rather exercise his options and thus partly recover the premium he paid for it.
In the context of this example, we can differentiate between two styles of options - the European (discussed in our example) and the American.
With the European style option, the manufacturer can exercise his option only on the expiration date.
The American style option gives the manufacturer the right to exercise it at any time before the expiry date (November 1st). In rare cases he can partially exercise it during its life. This option gives more flexibility, but it is more expensive than the European style option. In the previous example we can assume that the American style option will be priced at 7,500 BGN. In this case, for $100,000 at a fixed rate of 1.5500, the breakeven rate at which the manufacturer will cover his expenses for the premium (7,500 BGN) will be 1.6250 (1.5500 + 7,500/100,000).
In this way, throughout the life of the option, the manufacturer can exercise it, whenever he decides that it is advantageous for him to do so.
All issues concerning the European style options refer to the American options with the exception of the early exercise right.